Are FX Traders Getting Ahead of Themselves?

The recent rally in the U.S. dollar and Japanese Yen has many traders wondering if safe haven currencies are back in demand. The subtle but clear turn in risk coincides with the consolidation in the S&P 500 below 1515. While it can be said that the ECB’s comments on the euro and the dovishness of the RBA are to blame for the EUR and AUD’s slide against the greenback, it can also be argued that investors got ahead of themselves in the month January. At the start of the year, the enthusiasm in the currency and equity markets was strong but with central banks talking about the downside risks, investors are now starting to think that the outlook for the global economy may not be as bright as they believe. Central banks know that their recoveries are extremely fragile and they will want to avoid creating any additional risks and this may include endorsing a rally in their currency. However, it is important to remember that this is a year of recovery for many countries. The first half may be tough but many central banks are still looking for stronger growth in the second half of the year. For this reason, we believe the pullback in many major currencies will be temporary. This is not to say that there won’t be additional weakness in the near term, but we do not expect milestones to broken to the downside.

The lack of U.S. economic data surprises has made the dollar the least interesting currency this week. According to the latest report, jobless claims fell slightly to 366K from 371K. Continuing claims on the other hand increased from 3.216 million to 3.224 million. The U.S. trade balance is due for release tomorrow. The improvement in the ISM manufacturing index points to the possibility of a smaller trade deficit. This has been a quiet week for U.S. data but that will change next week with retail sales on the calendar.

Has ECB Draghi Permanently Killed the EUR Rally?

The European Central Bank left monetary policy unchanged, but comments from Mario Draghi sent the euro tumbling more than a full cent against the U.S. dollar. At first, it was Draghi’s subdued tone that sent the EUR/USD lower but the selling gained momentum as the ECB President started to talk about the currency. Taking a deep breath before answering the question posed by a reporter, Draghi said the euro appreciation is a sign that confidence is returning BUT exchange rages should reflect fundamentals. He said the real and nominal exchange rates of the euro are near their long-term average but if the appreciation is sustained, it may alter their view on price stability. In plain English, this means he’s comfortable with the current level of the euro but watching it carefully to see if the rally continues and if it does, they will have to reevaluate the impact on inflation. While Draghi believes that the exchange rate is not a policy target, the amount of time he spent talking about inflation in his prepared commentary suggests that the euro rally is impacting their view on monetary policy. Draghi said inflation rates could fall below 2% in the coming months but right now, the risks are broadly balanced. Indirect taxes and oil prices could drive prices inflation higher but appreciation of the exchange rate could drive CPI lower. Since price stability is the ECB’s number one priority, if the euro gets too strong, it could tip the balance in favor of lower prices, which could push the central bank to talk down the currency. According to Draghi, monetary policy remains accommodative because the risks to euro area growth continue to be to the downside. He believes there will be weakness in early 2013 as balance sheet adjustments weigh on the economy followed by a gradual recovery later in the year that will be supported by accommodative monetary policy. So the message from the ECB is crystal clear, monetary policy is accommodative and they ARE watching the euro. The question that many currency traders now have is whether Draghi has permanently killed the EUR/USD rally and our answer is no. Fundamentals remain intact – the tail risks have receded, the Eurozone economy is still recovering and capital is returning to the region. However, we cannot ignore the short term impact that Draghi’s comments have had on the euro. The currency appreciated significantly since the beginning of the year due in large part to Mario Draghi’s nonchalant attitude towards the currency. The euro is now on his radar and this reality could drive additional profit taking in the EUR/USD. However we believe losses should be limited to support around 1.3270. Back when ECB President Trichet called the move in the euro brutal or excessive, the currency pair recovered quickly before topping out months later on.

GBP: Saved by Carney

For the second time in 5 trading days, we have seen big moves in EUR/GBP. The magnitude of the move is approximately the same as the one on February 4th, which was the strongest one-day slide in the currency pair since September 2009. The GBP also rebounded against the USD but the move was small. U.K economic data was stronger than expected with industrial production rising 1.1% compared to a forecast for 0.9% growth and manufacturing production jumping 1.6% vs. 0.3% the previous month. The U.K.’s trade balance also narrowed to –GBP8.9 billion from –GBP9.27 billion. However it wasn’t economic data that really drove sterling higher because intraday charts show that the move did not happen until 5am ET, 30 min after the data was released and shortly after incoming BoE Governor Carney started to speak. Our colleague Boris Schlossberg summarized Carney’s speech perfectly. “Ahead of the testimony many market participants speculated that Mr. Carney who was the former head of the Bank of Canada, would propose a radical new direction for UK monetary policy perhaps even implementing such unorthodox measures as GDP targeting. However, Mr. Carney’s written responses to the Treasury committee questions seemed to suggest a much more conventional approach noting that the two core responsibilities of the central bank were price stability and financial stability seeming to emphasize the need for markets to have confidence in the capital markets. Mr. Carney did not address such controversial issues such as monetization of UK debt or direct targeting of the GDP but did note that there must be a need for quick debate on the framework of monetary policy in order to limit uncertainty. In short Mr. Carney appears to be willing to entertain fresh ideas regarding UK monetary policy, but his emphasis on the fact that the bar to altering flexible inflation targeting as practiced in Canada and UK is very high, suggests that he will move cautiously on any new policy initiatives” and that was enough to rally the GBP.

AUD: Poised for Further Losses?

The Australian, New Zealand and Canadian dollars fell sharply against the greenback on the heels of mixed economic data. At first glance, Australian labor market conditions appeared to improve with job growth rising by 10.4k and the unemployment rate holding steady at 5.4%. Unfortunately like New Zealand, the steadiness in the unemployment rate was caused by a drop in the participation rate which means that fewer Australians are working. Also, all of the job growth was in part time work which increased 20.2k. Full time jobs fell 9.8k in January, which means that on balance, job growth is still very sluggish. With the participation rate declining, consumer spending may have a tough time recovering. Support in the AUD/USD is now at 1.02. The New Zealand dollar dropped more than 1.0% today as selling in the currency pair accelerated after the weak employment numbers. The Canadian dollar also weakened but Canadian data was mixed with the new housing price index increasing slightly but building permits falling 11.2% against expectations for a 5.0% rise in the month of December. The next 24 hours will remain a busy one for the comm dollars with the RBA’s quarterly statement on Monetary Policy scheduled for release. This statement contains the central bank’s latest growth and inflation forecasts and considering that the RBA was dovish, the odds favor a weaker outlook, which could send the AUD even lower. Chinese inflation numbers are also due for release along with Canadian trade and employment numbers. Job growth is expected to slow after rising sharply in December.

JPY: Potential Replacements for Shirakawa

For the second day in a row, the Japanese Yen consolidated against the U.S. dollar. As mentioned in yesterday’s note, the gains in USD/JPY are being capped below 94 but rock solid resistance is at 95. While we believe that USD/JPY will test that level eventually, it is vulnerable to additional profit taking that could take the pair down to 92.35-92.50. Overnight there was a flurry of comments from Japanese officials. Bank of Japan Governor Shirakawa said they are cooperating with the government to support the economy. Finance Minister Aso defended the central bank’s monetary policies by saying that monetary easing does not constitute competitive Yen devaluation. Prime Minister Abe said he plans to propose all 3 BoJ candidates at the same time. The 3 gentlemen up for the job include Toshiro Muto, Kazumasa Iwata and Haruhiko Kuroda. All 3 are doves with Mr. Muto being the biggest supporter of easier monetary policy. Muto and Iwata both served as BoJ Deputy Governors between 2003 and 2008 and therefore have the most direct experience but that could also hurt them because the policies enacted during that time failed to boost growth or beat deflation. Kuroda is the president of the Asian Development Bank and many believe that he has the clout to represent Japan on the global stage. While last night’s leading and coincident indicator reports showed some improvement in Japan’s economy, the key will be tonight’s current account and trade numbers. Economists expect the deficit to narrow and that needs to happen to keep Japan’s recovery on track.

Having graduated New York University’s Stern School of Business at the age of 18, Ms. Kathy Lien has more than 13 years of experience in the financial markets with a specific focus on currencies. Her career started at JPMorgan Chase where she worked on the interbank FX trading desk making markets in foreign exchange and later in the cross markets proprietary trading group where she traded FX spot, options, interest rate derivatives, bonds, equities, and futures.

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Trading foreign exchange on margin carries a high level of risk and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading and seek advice from an independent financial advisor if you have any doubts.
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